Question

Effects of denominator-level choice. The Shen Company is a manufacturer of MP3 players. It installed standard costs and a flexible budget on January 1, 2009. The president has been pondering how fixed manufacturing overhead should be allocated to products. Machine-hours have been chosen as the allocation base. Her remaining uncertainty is the denominator level for machine-hours. She decides to wait for the first month’s results before making a final choice of what denominator level) should be used from that day forward.

In January 2009, the actual units of output had a standard of 28,000 machine-hours allowed. If the company used practical capacity as the denominator level, the fixed manufacturing overhead spending variance would be $4,000, unfavorable, and the production-volume variance would be $14,400, unfavorable. If the company used normal capacity utilization as the denominator level, the production-volume variance would be $8,000, favorable. Budgeted fixed manufacturing overhead was $48,000 for the month.

1. Compute the denominator level, assuming that the normal-capacity-utilization concept is chosen.

2. Compute the denominator level, assuming that the practical-capacity concept is chosen.

3. Suppose you are the executive vice president. You want to maximize your 2009 bonus, which depends on 2009 operating income. Assume that the production-volume variance is written off to cost of goods sold at year-end. Which denominator level would you favor? Why?

 

Answer 1

Effects of denominator-level choice.

1.         

Normal capacity utilization. Givens denoted*

 

2.      

Practical capacity. Givens denoted*

 

3.         

To maximize operating income, the executive vice president would favor using normal capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a smaller base than practical capacity, resulting in any year-end inventory having a higher unit cost. Thus, less fixed manufacturing overhead would become a 2009 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level.

To maximize operating income, the executive vice president would favor using normal capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a smaller base than practical capacity, resulting in any year-end inventory having a higher unit cost. Thus, less fixed manufacturing overhead would become a 2009 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level.